Tuesday, March 31, 2009

How Has India Been Hit By the Crisis?

14. The contagion of the crisis has spread to India through all the channels – the financial channel, the real channel, and importantly, as happens in all financial crises, the confidence channel.

15. Let us first look at the financial channel. India's financial markets - equity market, money market, forex market and credit market - had all come under pressure from a number of directions. First, as a consequence of the global liquidity squeeze, Indian corporates found their overseas financing drying up, forcing corporates to shift their credit demand to the domestic banking sector. Also, in their search for substitute financing, corporates withdrew their investments in domestic money market mutual funds (MFs); consequently, non-banking financial companies (NBFCs) where the MFs had invested a significant portion of their funds came under redemption pressure. This substitution of overseas financing by domestic financing brought both money markets and credit markets under pressure. Second, the forex market came under pressure because of reversal of capital flows as part of the global deleveraging process. Simultaneously, corporates were converting the funds raised locally into foreign currency to meet their external obligations. Both these factors put downward pressure on the rupee. Third, the Reserve Bank's intervention in the forex market to manage the volatility in the rupee further added to liquidity tightening. 16. Now let me turn to the real channel. Here, the transmission of the global cues to the domestic economy has been quite straight forward – through the slump in demand for exports. The United States, European Union and the Middle East, which account for three quarters of India's goods and services trade, are in a synchronized down turn. Services export growth is also likely to slow in the near term as the recession deepens and financial services firms – traditionally large users of outsourcing services – are restructured. Remittances from migrant workers too are likely to slow as the Middle East adjusts to lower crude prices and advanced economies go into a recession.

17. Beyond the financial and real channels of transmission as above, the crisis also spread through the confidence channel. In sharp contrast to global financial markets, which went into a seizure on account of a crisis of confidence, Indian financial markets continued to function in an orderly manner. Furthermore, our banks have continued to lend. However, the tightened global liquidity situation in the period immediately following the Lehman failure in mid-September 2008, coming as it did on top of a turn in the credit cycle, increased the risk aversion of the financial system and made some banks cautious about lending.

18. The purport of the above explanation is to show how, despite not being part of the global financial sector problem, India has been affected by the crisis through the adverse feedback loops between external shocks and domestic vulnerabilities

Housing Finance CompaniesFor the growing and important segment of housing finance companies, the CFSA has noted that having a National Housing Price Index and a Housing Starts Index is a priority.

Foreign Exchange MarketWith the economy moving towards fuller capital account convertibility in a calibrated manner, focussed regulation and monitoring of the foreign exchange market assumes added importance. There is though a need to strengthen infrastructure, transparency and disclosure, and product range in the forex derivatives segment. Strengthening the trading infrastructure, market conduct, transparency of Over-the-counter (OTC) derivatives in the forex market, accounting and disclosures in line with international practices, including disclosures by non-bank corporates, needs to be done on a priority basis. The recent introduction of currency futures is a step in this direction.

Government Securities MarketThe government securities market has witnessed significant transformation in its various facets: market-based price discovery, widening of the investor base, introduction of new instruments, establishment of primary dealers and electronic trading and settlement infrastructure. This is the outcome of persistent and high-quality reforms in developing the government securities market. Increased transparency and disclosures, gradual scaling down of mandated investments and development of newer instruments are some major areas which could be considered for further development. Regulatory incentives to increase the size of trading book could also be considered as a measure to further develop the government securities market.

Corporate GovernanceIn India, there is a comprehensive corporate governance framework in place for listed companies and the listing agreement forms an important pillar of corporate governance framework. There is a need to strengthen the corporate governance framework with regard to risk management in listed companies. Listed companies need to disclose the reasons for non-compliance with non-mandatory requirements. Steps need to be taken to protect the interests of shareholders, such as equitable treatment of all shareholders including minority shareholders and alternate methods of voting, which are convenient for shareholders and in which investor associations can play a constructive role. There is a need for strengthening the disclosure mechanism to bring about greater transparency in ownership structures and stringent penal action needs to be taken where such practices are unearthed. Penal provisions for fraudsters may be strengthened in corporate law by providing for disgorgement of gains and confiscation of assets. The corporate governance framework needs to evolve with the changing times and there is a parallel need to strengthen the corporate governance framework for unlisted companies.Transparency in Monetary PolicyIndia is largely compliant with the IMF’s Code of Good Practices on Transparency in Monetary Policy. The roles, responsibilities and objectives of the Reserve Bank are well-defined. The Reserve Bank has explicit multiple objectives of monetary policy with changing relative emphasis. It also follows a multiple indicator approach, which has been reasonably effective. The present legislative framework provides enough room and manoeuvrability for the Reserve Bank to operate monetary policy in consonance with evolving needs and circumstances. The key element of the framework at present is the flexibility enjoyed by the Reserve Bank while going about its assigned task of maintaining the monetary stability of India. The main issues that have come out of the assessment of transparency in monetary policy pertain to the review of legislations with regard to the objectives of monetary policy, the issue of operational independence and accountability of the Reserve Bank and the separation of debt management from monetary management.

As far as the issue of operational independence of the central bank is concerned, the Reserve Bank enjoys independence vis-à-vis the executive arm of the state through conventions, agreements and MoUs in specific areas. The specification of procedures and reasons for the removal of the Governor/Deputy Governor as also for supersession of the Board could potentially lead to the loss of well-established de facto independence. Any modifications that might be required to strengthen monetary policy as also the regulatory framework might be carried out by necessary amendments to existing legislations as needed, which would not call for a fundamental review of legislations or an overhaul of the existing legal framework. The CFSA feels that an overhaul of legislation may not be appropriate at the current juncture.

Following the announcement in the Union Budget 2007-08, the Central Government is proceeding with the establishment of a Middle Office, as a prelude to setting up of a full-fledged Debt Management Office (DMO). While most members of the CFSA concurred with the proposal to set up a DMO, one member felt that the DMO should be an independent body. The Chairman, however, was personally of the view that the time is not ripe for the complete separation of debt management from the Reserve Bank at the current juncture.Transparency in Financial PoliciesThe Reserve Bank, SEBI and IRDA are compliant with the relevant standards in transparency in financial policies. Any move to institutionalise the High Level Coordination Committee for Financial Markets (HLCCFM) could prove to be counter-productive as it could reduce flexibility in the formulation of financial policies; however, the present information-sharing mechanism could be improved.

Fiscal TransparencyThe major area of concern arising out of the assessment of fiscal transparency is in the reporting of off-budget items, like oil bonds, and the need to have an additional augmented fiscal deficit measure to capture these items. Likewise, any move towards accrual-based accounting should also be attempted in a gradual manner.